REITs: Liquid exposure to concrete gold with high yield sensitivity

REITs: Liquid exposure to concrete gold with high yield sensitivity DR BERND MEYER CFA HEAD OF CROSS ASSET STRATEGY dr.bernd.meyer@ commerzbank.com ULRICH URBAHN CFA, SENIOR CROSS ASSET STRATEGIST ulrich.urbahn@ commerzbank.com MAX KETTNER CROSS ASSET STRATEGIST max.kettner@ commerzbank.com REITs (Real Estate Investment Trusts) provide an easy and liquid way to gain exposure to another real asset concrete gold which unlike other real assets generates an income stream. Fuelled by the hunt for yield, REITs were the best asset class in 214, as safehaven yields slid into uncharted territory. In early 215, they performed strongly, but have underperformed recently as global bond yields rebounded. Here, we introduce Emerging Markets (EM) REITs and look at which global regions and sectors are relatively attractive on valuation and less yield sensitive, as we believe further differentiation is needed in the run-up to the first Fed rate hike. PAGE 2: REITS THE EASY WAY TO INVEST IN PROPERTY MARKETS PAGE 2: REITS WERE FUELLED BY THE HUNT FOR YIELD IN 214 AND EARLY 215 PAGE 3: REITS SECTORS AND EM REITS PAGE 3: SHOULD A FED RATE HIKE BE FEARED? PAGE 5: YIELD SENSITIVITY AND VALUATION OF REITS REGIONS AND SECTORS PAGE 6: DISCLAIMER AND CONTACTS 1

REITS THE EASY WAY TO INVEST IN PROPERTY MARKETS REITs are an easy, transparent, liquid and tax-efficient way to invest in global property markets. They are companies that own and let properties, and fulfil certain legal requirements, ensuring the bulk of their business activity is property lending and that at least 9% of the net income is distributed in the form of dividends. REITs have traditionally been the focus of yieldhungry investors, given their high and stable dividend yield, that is still in excess of the global equity dividend yield and Treasury yields. In addition, REITs tend to apply higher financial leverage than equities. For these reasons, they are more sensitive to changes in bond yields (see Chart 1). REITs usually enjoy special tax status, with little to no requirement to pay taxes at the company level. The combination of tax efficiency and high liquidity is not found in other forms of real estate investment, making REITs an excellent choice for investors looking to invest in another real asset, namely property, or concrete gold. REITS WERE FUELLED BY THE HUNT FOR YIELD IN 214 AND EARLY 215 In 214, REITs were the best asset class and considerably outperformed equities. This development was mainly driven by falling interest rates and the global hunt for yield, which were supportive of REITs due to their high financial leverage and high dividend yield (see Chart 1). In early 214, we had expected REITs to fare well that year, as they had substantially underperformed our model-implied return in 213 (see Chart 2). However, the strength of the run surprised everyone. Developed Markets (DM) REITs outperformed equities by 1.4 percentage points (pp) in 214, with all regions, apart from Japan, outperforming their respective equity markets. UK REITs were the strongest outperformer with almost 2pp outperformance versus the blue-chip stocks. In absolute terms, US and Europe ex UK REITs exhibited the strongest performance. Chart 1: REITs outperformance versus equities depends heavily on yield development Relative performance of DM REITs versus DM equities and 1-year US Treasury yields 1.3 1.2 1.25 1.2 1.7 1.15 2.2 1.1 1.5 2.7 1..95 3.2.9.85 3.7 211 212 213 214 215 Ratio: REITs /Equities 1-year Treasury yield (percent, inverted, right axis) Source: Bloomberg, Commerzbank Research Chart 2: REITs no longer over-deliver compared with our model-implied return REITs no longer over-deliver compared with our model-implied return 8 6 4 2-2 -4 -.8pp gap between realised and -6 estimated performance -8 1977 198 1983 1986 1989 1992 1995 1998 21 24 27 21 213 Realised 12-month return Estimated 12-month return Source: Bloomberg, Commerzbank Research, as at 3/4/215 This meant that REITs not only closed the gap between the model-implied and the actual return but markedly over-delivered. By the end of January 215, we found that REITs exceeded the model-implied return by 17.7pp over the previous 12 months. In turn, we became more cautious and halved the overweight of REITs in our Cross Asset Portfolio at the beginning of February. Since then, REITs have underperformed equities as safe-haven bond yields backed up. This roller-coaster ride also resulted in a similar scenario for the relative performance Falling interest rates and the global hunt for yield were supportive of REITs, due to their high financial leverage and high-dividend yield 2

of REITs versus equities (see Chart 1). As a result, REITs have now underperformed equities since the start of the year. By region, only UK REITs have outperformed their respective equity peers since the start of the year. In particular, Japan, Hong Kong and US REITs have underperformed their equity markets quite considerably year-to-date. REITS SECTORS AND EM REITS Table 1 shows that the largest weight in the DM REITs universe belongs to the diversified sector, followed by the retail sector, which together account for more than 5% of the index. US REITs are much more balanced than non-us regions, which largely consist of diversified REITs. The sector mix is important for investors, as each sector has distinct features and therefore exhibits differing sensitivity to changes in interest rates. For emerging markets, the EM REITs Index began in December 28. It comprises 154 REITs with a total market cap of roughly USD149bn, which compares with 312 REITs and a market cap of USD1.3trn for DM REITs. Apart from the smaller size, the EM universe is also much more concentrated: the top ten constituents account for more than 35% of the market capitalisation, while in the DM index this figure is just 22%. Table 1: Sector mix is heterogeneous across regions US REITs much more balanced than non-us REITs, where diversified REITs dominate Weight matrix of different REITs regions and sectors, percent United States Europe (incl UK) UK Asia DM Diversified 8.2 4. 54.6 56.9 27.7 Healthcare 13.5.5 1.3 na 7.4 Industrial 4.5 3.4 7.5 8.2 5.4 Industrial/ Office 2.8 na na 1.5 1.9 Resorts 7.9 na na.7 4.4 Office 12.6 9.4 7.6 12. 11.9 Residential 16.6 14.7 3.5 1.7 12.1 Retail 27.6 3.9 22.6 18.9 25.8 Self Storage 6.3 1.1 2.8 na 3.5 Developed markets 56.3 15.4 6. 28.3 1. Source: EPRA/NAREIT, Commerzbank Research, as at 18/2/215 Chart 3: EM REITs universe tilted towards Asia Pacific and in particular China The EM REITs universe is tilted towards EM Asia Pacific, much like the regional structure of EM equities (see Chart 3). Index weights in EM REITs index, percent EM REITs EM Equities A closer look reveals that Chinese REITs are by far the largest weight within this sub-index, and account for roughly 36% of the overall EM index, followed by South Africa (13%) and the Philippines (8%). In terms of sector structure, the bulk of 2.8% 4.9% 6.6% 15.5% 17.2% 67.3% EM REITs are in the diversified (65%), residential (22%) and retail (1%) sectors. 13.7% EM REITs have been underperforming DM REITs consistently in the past few years. This is in line with EM equities underperforming DM equities during the same period, although there was a slight rebound of EM assets in recent weeks due to the likely delay of the Fed lift-off. However, there are considerable differences in terms of performance within EM REITs: LatAm and EM Europe, particularly, have performed poorly, while EM MEA and EM Asia Pacific have been outperforming, with EM MEA REITs outperforming DM REITs. SHOULD A FED RATE HIKE BE FEARED? Historically, REITs have weathered the start of central bank rate hike cycles relatively well, but their relative performance to equities shows considerable volatility. Given this, we are not sceptical about REITs per se, only because the Fed is expected to start tightening this year. EM Asia Pacific EM Europe EM Asia LatAm EM LatAm EM Mea EMEA Breakdown of 6.6 percent EM REITs, EM Asia Pacific, percent 59.8 6 4 2 12.2 9.5 8.1 7.3 3. China Philippines Indonesia Malaysia Thailand Other Source: Bloomberg, Commerzbank Research, as at 13/2/215 Moreover, we discovered a shift in how the relative performance of REITs versus equities is related to the yield development. 3

What has changed in recent years is that REITs do not seem to be related as much to front-end yields as to long-end yields. Why is this? For one, the impact of rising yields on the refinancing of REITs was previously a focus, resulting in a stronger sensitivity to the maturities at which the re-financing happens: the shorter to middle part of the yield curve. With the hunt for yield kicking in, the main impact no longer came from refinancing but from the level of the REITs dividend yield compared with the yields of other assets. REITs compete with the highest yielding bonds (ie the ultra-long end of the curve), raising the sensitivity of ultra-long-term yields to the relative performance of REITs versus equities. The EM REITs universe is tilted towards EM Asia Pacific, much like the regional structure of EM equities In addition, increased sensitivity to long-end yields was, at least, partly because the visible bull-flattening meant that strongly declining long-end yields were coinciding with rising or unchanged short-term yields. Our model-based return estimates incorporate the slope of the yield curve as an explanatory factor. We have shown in the past that REITs returns depend negatively on the development of the curve, and a flattening of the yield curve tends to be positive for REITs. Our economists expect the US lift-off will not occur until September 215 at the earliest. However, they have also adjusted the expected path of monetary tightening and anticipate rather 4

We believe Fed rate hike uncertainty necessitates more differentiation in REITs gradual upward moves for Fed fund rates. Therefore, we believe the long-end of the Treasury curve will remain relatively immune to Fed rate hikes and, going forward, any underperformance of REITs versus equities should not be pronounced. YIELD SENSITIVITY AND VALUATION OF REITS REGIONS AND SECTORS Charts 4 and 5 show our relative valuation and rate-sensitivity scoring models. This scoring model is based on six different valuation measures (eg P/E ratio, dividend yield) in order to detect relative attractiveness on valuation grounds. For yield sensitivity, we incorporate four different leverage ratios, as well as historical correlations and sensitivities to yield changes. The regional scoring model differentiates between relative valuation based on current levels and relative valuation based on valuation compared to history. The difference between the former and the latter illustrates that part of the regional valuation divergence on current levels is structural, eg different sector structures. However, this message remains similar. Our scoring model shows that Asia Pacific ex Japan, in particular, as well as Hong Kong, look attractive and should weather a potential US rate hike fairly well as their valuation and rate sensitivity is relatively favourable. In contrast, the US looks to be the most vulnerable. The residential, healthcare and office sectors seem to be more vulnerable due to their negative valuation and rate sensitivity scores. In contrast, industrial and diversified REITs look more attractive in terms of valuation and rate sensitivity. Chart 4: Asian REITs ex Japan look attractive... Valuation Score Europe excluding UK Europe excluding UK EM US US EM UK UK 4 3 2 1-1 -2-3 Japan Asia Pacific excluding Japan Hong Kong -4 Vulnerable -5 Japan -6-4 -2 2 4 6 Debt & Rate Sensitivity Score Attractive Relative valuation based on current levels and relative rate sensitivity Relative valuation based on valuation compared to history and relative rate sensitivity Source: Bloomberg, Commerzbank Research, as at 5/5/215 Chart 5:... as well as industrial and diversified REITs Valuation Score Healthcare Retail Office Residential 4 2-2 Industrial/Office Diversified Industrial Attractive Resorts Vulnerable -4-6 -4-2 2 4 6 Debt & Rate Sensitivity Score Relative valuation based on current levels and relative rate sensitivity Source: Bloomberg, Commerzbank Research, as at 5/5/215 SUMMARY REITs are an easy, liquid and tax-efficient way to invest in another real asset: concrete gold. DM REITs were the bestperforming asset class in 214 and continued this strong run in early 215. Since then, they underperformed equities as safe-haven bond yields stabilised and rebounded. Given the generally higher yield sensitivity of REITs than equities, we believe that Fed rate hike uncertainty necessitates more differentiation in REITs going forward. In terms of their relative valuation and rate sensitivity, we find Asian REITs, bar Japan, look attractive while US REITs seem more vulnerable. Among sectors, industrial and diversified REITs are less yield sensitive and more attractively valued. 5

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